ReaganD (99.90)

How to Hedge Short Positions in Both Bull and Bear ETFs

August 27, 2009 – Comments (2) | RELATED TICKERS: EDC , FAS , TNA

One can short both the 3x Bull and 3x Bear ETFs on the same underlying index to capture the so-called "volatility decay" of 3x ETFs, which I have described in older posts.  This strategy requires daily rebalancing to ensure that the two short positions are equal in dollar value.  It shows the best returns in sideways markets in which there is intraday volatility and interday reversion to the mean.  I look at the implied volatility of options on the underlying index or the 3x ETFs to determine which 3x ETFs might be the most volatile in the near term.  Currently, the market expects Emerging Markets to be volatile in the future.  Financials have been the most volatile over the past year or so.

I have attempted to figure out how minimize drawdowns associated with this strategy because they can be quite large if the market is up every single day or down every single day.  I have come up with 2 possible hedges and would like some feedback.

1.)  Simply buy the underlying index and short the 3x bull and short the 3x bear.  Bull markets tend to be less volatile than bear markets for psychological reasons.  To visualize this, graph the VIX against the S&P500.  In a raging bull market, gains on the underlying index will compensate for some of the losses on the short positions in 3x ETFs.  I have attempted to backtest this strategy by accounting for how 3x ETFs would have performed on various underlying indexes like the NASDAQ or the S&P500 over many decades.  I find it difficult to account for the daily rebalancing that would be necessary to follow this strategy.  

 2.)  Open a straddle position on the underlying index (i.e. buy calls and puts with strike prices at the current price).  Doing so, would protect you in the event that the market goes straight up or straight down.  

Let me know what you think.